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How Catastrophic Failures of the Past Can Inform Our Financial Future


As Cheick Amadou Hampate Ba said, “Tales are the stories of yesterday, told by today’s men, for future generations.” Today’s story is sad, as it narrates the failure of one of the best-known investment companies in history. Long-Term Capital Management (LTCM) was extremely different from its counterparts. Its performance and the prestige of its partners gave confidence and made the investment community optimistic about the odds of its lasting success. For some people, they were “in effect the best finance faculty in the world.” As Scholes, one of its prominent partners, stated: “We’re not just a fund. We’re a financial technology company.” However, just as the sinking of the Titanic 110 years ago shocked and troubled the world, the unexpected crisis of LTCM was at the heart of investment discussion 24 years ago. To demystify the unsuccessful venture of LTCM and learn from the wisdom behind this miscarriage, we will examine four stages for our analysis: the birth of LTCM, the background of LTCM, its rise, and finally its unexpected breakdown. We will not focus in this article on the company’s lack of transparency, which is also relevant because of the downside of asymmetrical information in the market.

1. The Boom of the hedge fund and the birth of LTCM

My generation is highly influenced by the breakdown of Lehman Brothers in 2008. Just as singer memorize all their lyrics, so do this generation ‘s finance students memorize the recent failure of Evergrande – a Chinese real estate developer – as well as the crisis of Archegos Capital Management. Likewise, the story of LTCM is relevant to the public. In my humble point of view, it should be taught to all business students, just as learning about the sinking of the Titanic is an unavoidable subject for students of maritime history. With LTCM, students interested in finance can find a case study that epitomizes the danger of high leverage for a firm and the entire investment system. Aspiring entrepreneurs who want to build tomorrow’s investment companies can learn from the mistakes of LTCM’s huge empire. Now, let’s take our time machine and go back to 1994, when LTCM was first formed as a hedge fund. This term embodies any pooled investment vehicle deploying a wide range of strategies to beat the market. During the 1990s, the idea of creating hedge funds was very popular. Due to the explosion of the stock market, six million people worldwide were becoming millionaires. For those lucky people, investing in hedge funds held a special appeal, and in order to meet investment demands, this boosted the number of hedge funds considerably. According to a survey by the Securities and Exchange Commission, there were only 140 such hedge funds in 1968, while during the 1990s, the number of hedge funds reached 3,000, managing between 200 billion and 300 billion dollars in capital. Hedge funds were also seen as flexible investment vehicles for many finance professionals. The Investment Act of 1940 limited mutual funds to having a strong leverage effect. In fact, mutual funds couldn’t be heavily indebted like hedge funds; their level of leverage couldn’t exceed 33%, or one-third of their total asset. The SEC also reduced its exposure to illiquid derivatives (15% of the net asset, or when it comes to the money market fund, 10%). In any case, a sense of financial freedom, combined with this period being the heyday of investments, led to the creation of numerous hedge funds. John Meriwether, preoccupied by the market, launched a hedge fund when he decided to revive his career. Hedge funds are naturally risky and can lead to severe capital loss. In order to protect investors with little knowledge, hedge funds are restricted to wealthy individuals and institutional investors. The assumption driving this restriction is that these people tend to possess keen knowledge about various assets. Moreover, they are usually well diversified across the market, so a loss within one asset class can be offset by a gain in another. LTCM was welcomed with great enthusiasm in the corporate world due to the outstanding composition of its members – a perfect mix of talented professionals and geniuses of financial theory.

2. A Background That May Have Predicted Their Future

Wall Street, like Silicon Valley, is a place where numerous businesses rise and make their owners vastly wealthy. These two places reward success and the entrepreneurship mindset, but they also sadly become the gravesites of many companies. LTCM was a bright company gathering the best minds of Wall Street. Theoretically, the company was not expected to fail. Take a look at the composition of its partnership. If only one name should be carved in stone, that of Meriwether should be consigned to eternity. Meriwether did all the heavy lifting to create LTCM. Born in 1947, he spent his childhood in Rosemoor, Chicago. He was a very clever student, mainly in mathematics and the subject of trading. After graduating from the University of Chicago in business, he began his career at Salomon Brothers as a bond trader. His aptitude got him promoted to the head of the domestic fixed-income arbitrage department. He succeeded marvelously in this duty, and his team contributed to a major part of Salomon Brothers’ earnings. In fact, in 1990, the department he oversaw at Salomon Brothers participated in 87% of the company’s total earnings. Consequently, LTCM was created to imitate the same strategies used at his previous company. Roughly speaking, in Meriwether’s mind, LTCM should have been a closely related and more advanced picture of Salomon Brothers’ domestic fixed-income department. However, Meriwether’s genius went beyond his trading skills. He revolutionized the hiring culture of Wall Street by tackling the old world. The disruption he brought about changed the conventional hiring system and shaped the new Wall Street. Prior to the 1990s, Wall Street was ruled by a culture of anti-intellectualism. Most Wall Street managers were reticent about hiring academics at the heart of their trading departments. The prevailing mindset was that the research department was the place best suited to the scholar in the corporate world. As stated in the first chapter of When Genius Failed: “He took a bunch of guys who in the corporate world were considered freaks.” As a result, LTCM’s human resources were luxurious. On the one hand, there were experienced and outstanding professionals of the finance universe who came primarily from Salomon Brothers. We can cite, for example, David W. Mullin, at that time the Vice Chairman of the US Federal Reserve. On the other hand, there were also brilliant finance professors. We can list plenty of names, including Erick Rosenfeld (an instructor at Harvard University) and Victor J. Haghani (who held a master’s degree in finance from London Business School). However, two men in particular stood out among this intelligent constellation. Robert C. Merton and Myron. S. Scholes contributed tremendously to the advancement of finance. Their incredible work on a new method to determine the value of an option was rewarded by a Nobel Prize in Economics in 1997. From a modern perspective, LTCM looked like a basketball team that had recruited Lebron James, Kevin Durant, and Stephen Curry. The combination of its skillful professionals and dexterous scholars afforded the company many opportunities. First, it negotiated the haircut at a reasonable level. Second, the prestige of its constituents alleviated its funding. The conditions of investing in LTCM’s fund were strict and different from other hedge funds. For example, the fees were very high – a 25% performance fee on profit and a 2% fee on asset. Moreover, LTCM required investors to invest an initial 10 million and to keep this capital for at least 3 years. Nonetheless, these restrictions didn’t prevent the company from raising 1.25 million in capital as it gathered all the necessary weapons to succeed enduringly in the industry. When Genius Failed:“He took a bunch of guys who in the corporate world were considered freaks.” As a result, LTCM’s human resources were luxurious. On the one hand, there were experienced and outstanding professionals of the finance universe who came primarily from Salomon Brothers. We can cite, for example, David W. Mullin, at that time the Vice Chairman of the US Federal Reserve. On the other hand, there were also brilliant finance professors. We can list plenty of names, including Erick Rosenfeld (an instructor at Harvard University) and Victor J. Haghani (who held a master’s degree in finance from London Business School). However, two men in particular stood out among this intelligent constellation. Robert C. Merton and Myron. S. Scholes contributed tremendously to the advancement of finance. Their incredible work on a new method to determine the value of an option was rewarded by a Nobel Prize in Economics in 1997. From a modern perspective, LTCM looked like a basketball team that had recruited Lebron James, Kevin Durant, and Stephen Curry. The combination of its skillful professionals and dexterous scholars afforded the company many opportunities. First, it negotiated the haircut at a reasonable level. Second, the prestige of its constituents alleviated its funding. The conditions of investing in LTCM’s fund were strict and different from other hedge funds. For example, the fees were very high – a 25% performance fee on profit and a 2% fee on asset. Moreover, LTCM required investors to invest an initial 10 million and to keep this capital for at least 3 years. Nonetheless, these restrictions didn’t prevent the company from raising 1.25 million in capital as it gathered all the necessary weapons to succeed enduringly in the industry.

3. The Peak of the Mountain

LTCM appeared very glamorous to its shareholders during its rise. The company was at the top of the food chain and growing considerably. Its performance was both top-notch and spectacular. Consequently, it generated remarkable figures. For instance, the company engendered a 40% return net of fees in 1995 and 1996 (2.1 billion in 1996 as a total profit). During that benign era, all its trades were flawless. To return to When Genius Failed, Chapter 3: “But in 1994, Long-Term was almost never wrong. In fact, nearly every trade it touched turned to gold.” The secret of the company’s trades was rooted in convergence strategy or relative value. According to Investopedia, the term “convergence” is the opposite of “divergence.” It is used to describe the phenomenon of the future price and cash price of the underlying commodity moving closer together over time. Partners have faith in this strategy, just as some people rely on the loyalty of their boxers: “People may betray you but the right pair of boxers – never” (Helene Oyeyemi, Peaces). This strategy takes advantage of the inefficiency of the financial market to arbitrage among securities. For some theoreticians, the financial market is deemed perfectly efficient, which means the prices of securities reflect all information. These thinkers advocate for passive investment because they don’t believe active management can outperform the market in long run. As John C. Bogle said, “The evidence powerfully confirms that, at least in the mutual fund industry, the holy grail doesn’t exist. But investors seem hell-bent on carrying out the search for winning funds of the future, no matter how futile the search has proven to be.” The professors and other members of the LTCM team were aware that the opportunities to find these mismatches in market efficiency were few and far between. Therefore, they targeted all arbitrage opportunities worldwide, primarily in the bond market. The bond market was the favorite arena of John Meriwether and his crew. Like Nick Carraway in The Great Gatsby “ I decided to go east and learn the bond business. Everybody I knew was in the bond business, so I supposed it could support one more single man.” The partners saw in the bond market the best field in which to use their firepower. One of their masterpieces was their trade related to the US Treasury Bond. In 1994, when LTCM started its business, the bond market was experiencing a serious disturbance. Many hedge funds lost considerable amounts of money – for example, George Soros wasted 650 million of his client’s money in two days. This chaos and anxiety expanded the spread of the bond market worldwide to an absurd level. The partners of LTCM noticed that the spread between the US Treasury’s off-the-run and on-the-run bonds was uncommon. The off-run was trading at a yield of 7.36% while its counterpart was trading at 7.24%. The partners bet that this unfamiliar spread would shorten, and they made 15 million dollars in profit from this trade. Using the same strategy, they made 200 million on British gilts and 600 million on Italian bonds during their first two years alone. This performance was fueled by a high level of leverage, propelling their exploits to incredible heights. Leverage played a massive role in their accomplishments, almost supernaturally increasing their ROA from a small number of 2.45% (without leverage) to a breathtaking figure of 42.8% in 1995. However, as we know, in corporate finance, using too much borrowed money is like skating on thin ice.

3. The Results of an Ever-Changing Financial Landscape

Leverage is a defining trait of funds. In this context, the term encompasses balance sheet leverage but also economic leverage, which LTCM and other hedge funds generally realized by using specific strategies such as repo financing or derivative transactions. Their model of risk management in comparison to their time was futuristic and estimated the potential losses for the whole portfolio. According to their revolutionary model, the maximum amount of loss they could face on any single trading day was 45 million dollars, and the likelihood that the major part of their capital could vanish over the space of a month was unlikely. Influenced by Merton and Scholes, the assessment of volatility was a quintessential part of their model. The assumption that volatility remained unchanging impacted their trading style and was reinforced by the belief that the market was efficient. Therefore, the market had the amazing power to remedy all phenomenal deviations, while the prices of securities would naturally return to their historical levels. However, “a basic insight in financial economics is that the markets tend to self-correct, so Long-Term Capital Management was confident that a period of unusual losses would be followed by compensating gains in the portfolio’’ More money than God. The idea that the market would inevitably cure all inconsistencies gave them strong enough faith to leverage incredibly in order to realize profits on such small differences. However, the universe and the market particularly contain many surprises, both good and bad, for those who dare to go beyond our wildest imaginations. The story of LTCM is an example of our weakness in the face of a changing world. No matter how genius we are, the dynamic of the world will always surprise us. A recent war in Europe between Ukraine and Russia is a contemporary illustration that more prudence should be used when making forecasts. A minority of people expected that almost 77 years after World War Two, Europe would be on the verge of a new conflict. The turmoil in the Asian market, followed by the Russian debt crisis, triggered the collapse of LTCM’s fund. Unlike what the partners predicted; these challenging events affected the common behavior of securities prices. Instead of narrowing over time, the spread between the securities in different markets increased as time went on. As one clear example of this, on August 21st, 1998, the mortgage spread increased from 107 points to 121. Meanwhile, the high-yield bond grew from 269 to 276, and the off-the-run Treasury followed the same pattern from 8 points to 13 points. These unexpected and unpleasant changes in price routines devastated the fund’s performance. That day on August 21st, 15% of LTCM’s capital evaporated, and they recorded a loss of 553 million dollars in a single day of trading. On Thursday, August 27th, they achieved their second-worst performance – an incredible loss of 277 million dollars. LTCM was trapped by the same model that, in the past, had turned them into a god of finance: their cheat code of relative value strategy and leverage. As Merton Miller said, “In a strict sense, there wasn’t any risk if the world had behaved as it did in the past.” As mentioned in the previous paragraph, using high leverage is like skating on thin ice. Like an atomic bomb, leverage enlarges your return when the bet occurs in your favor. Likewise, your losses are also made greater when you are wrong on your bet. LTCM was betting with high leverage on both sides. In terms of their balance sheet, the leverage ratio was 28 to 1 at the end of 1997, and the national amount of the OTC derivatives position for the same period was 1.3 trillion. These geniuses were facing serious losses, and in such a case, high-leverage investors generally have two ways out:

- Raising new capital. Despite their attempt to convince investors that the prices of securities would spring back, this effort was unsuccessful in attracting new investors during these troubled times. “Meriwether was running out of friends. When you need money, Wall Street is a heartless place” (When Genius Failed, Chapter 7).

- Another way to exit is to sell your position in order to decrease the losses accelerated by high leverage. Under normal market conditions, buying and selling securities offers permanency. During times of stress, an investor behavior known as “flight to quality” occurs. Driven by panic, investors are looking for the safest assets. They reallocate their portfolios from risky assets to less risky assets. Thus, such behavior dries up liquidity in the market mostly for risky assets, which cannot find any buyers. Consequently, LTCM faced another additional problem: the liquidity issue. LTCM was highly leveraged but also had an enormous position in many markets. Reducing such a position in a time of panic is generally unthinkable.

- 4. Lessons Learned

- As the Dalai Lama once said, “If you think you are too small to change things, try to sleep in the same room with a mosquito.” How did the hedge fund crisis threaten the financial system? Why did the problem related to LTCM cause the involvement of the federal government to resolve the situation? In order to prevent a systemic financial crisis, the federal government stepped in and organized a bailout of 3.65 billion dollars on September 23rd, 1998. LTCM and hedge funds in general weighed less than other segments of the US financial market at the end of 1998. For instance, commercial banks had 4.1 trillion in total assets, and private pension funds 4.3 trillion, but the Securities and Exchange Commission (SEC) estimated the total assets under management to be between 800 billion to a trillion for hedge funds during 1998. However, the investments of major banks and their lending practices with LTCM led to a serious downfall for the whole financial system. Leverage is important in the free market system, and tightening credit could be disastrous for growth. Likewise, too much debt can negatively affect the system. However, one of the most stringent points of wisdom behind this story is to always monitor leverage. In the amazing work done by The President’s Working Group on Financial Markets after LTCM’s lack of success, according to Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, page 23: “When leverage investors are overwhelmed by market or liquidity shocks, the risk they have assumed will be discharged back into the market. Thus, highly leveraged investors have the potential to exacerbate instability in the market as a whole.” The failure of LTCM should be analyzed in the context of the market as a whole because LTCM was only the emerging part of the iceberg. During the twilight of the 1990s, Wall Street was over-leveraged (25 to 1) and derivatives soared considerably (22 trillion for the interest rate swap in 1997 against two trillion in 1990). Such a level of leverage is unsustainable. Therefore, policymakers should think about how to evaluate leverage for financial institutions, and all participants in the market should play their role in order to avoid such disaster. As mainly the first provider of derivatives, banks should not be careless in their offers of credit. A strong review of firm risk profiles should outpace their greed for returns by efficiently using tools such as collateral. Just as some men find it hard to resist women who smile at even their worst and most ridiculous jokes, banks tend to forget their principles of prudence mostly when the economic weather is sunny. They offer credit easily and lower their standards as PSG experiences their remontada. Do you think the story of Long-Term Capital Management and other such firms can lead banks to self-discipline in favorable times?


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Hu Man
Hu Man
15 jun 2022

Article généreux et pertinent ! Merci

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merci pour ton commentaire positif.

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